Qantas challenge may become a bumpy ride

THE savage domestic airfare war between Qantas and Virgin Australia will continue to play out this year after Qantas boss Alan Joyce sent a clear message to competitors that he would continue to pour excess capacity into the market - and sacrifice profits - to protect the airline's 65 per cent market share.

It is a high-stakes game. In the past six months a decision by Qantas to release 10 per cent excess capacity into the market wiped more than $100 million in profit from its domestic airline business.

Put simply, if Qantas hadn't retaliated, or only half retaliated by pumping 5 per cent extra capacity into the market in the past six months, its group profit would have looked between $50 million and $100 million better than it did.

The Qantas domestic business is a jewel in the airline's shrinking crown. To put it into perspective, in the past six months Qantas domestic profit fell to $218 million from $328 million in the previous corresponding half.

Intricately wrapped in the success of the domestic business is the group's loyalty program business, which has nine million customers and generates profits of $137 million.

It explains why Joyce is fighting tooth and nail to protect what he calls his 65 per line in the market share sand. Indeed, on Thursday he told investors that the airline was prepared to put between 5 and 7 per cent extra capacity in the domestic market - or even more if required - depending on Virgin and Tiger.

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It is based on a belief that the airline industry works on the ''S-Curve'' phenomenon, which measures capacity share against revenue share. The theory is there is a certain profit optimisation point where if you add more capacity you get little in the way of increased revenue, but if you lose capacity, revenue falls off a cliff.

According to a paper published by McKinsey & Company in 2006, the S-Curve is based on the premise that airlines which provide a high frequency of flights attain disproportionately high market shares. The high margin corporate market flies with carriers that offer the most flights, lounges and a loyalty program.

''With the S-Curve in mind, network managers around the world have been building dominant positions at airports and on routes, to capture the revenue premium that goes with such dominance. Additionally, managers have tried to limit the damage in those markets in which they are disadvantaged. They do this either by matching competitors' frequencies (often triggering unnecessary overcapacity), and/or by focusing on connecting traffic or by withdrawing altogether,'' the paper argues.

The problem with the ''S-Curve'' is it breaks down when there is low cost carrier competition and works best when there is a level playing field of two legacy carriers. In the 2006 McKinsey report, it argues that management needs to move on from the S-Curve model. ''The S-Curve principle has been 'hard-wired' in the heads of many network planners for decades. Nevertheless, times are changing and airlines need to take stock of what does and doesn't work,'' the report says.

Given Joyce is a fan of the ''S-Curve,'' he will be praying that if he pours enough excess capacity into the market it will force Virgin and Tiger to retreat. On Thursday he confirmed more capacity in the second half and said the airline would reconfigure the interior of 20 A330-200 aircraft for domestic use and buy five additional Boeing 737-800 aircraft.

It is not the first time airlines have dumped extra capacity in the market and it won't be the last. But the dynamics have changed. Qantas has a low-cost carrier and is competing against Virgin, which was a low-cost carrier but has moved up the value chain to take on Qantas, and if the ACCC gives it the green light to buy 60 per cent of Tiger Australia, it will move down the value chain to take on Jetstar.

The disadvantage for Qantas is Virgin has a relatively lower cost base than Qantas, and Tiger has a lower operating model than Jetstar.

Combine this with Virgin's decision to buy West Australian airline Skywest to take on Qantas' regional airline QantasLink and the competition is starting to look stiff.

It looks even stiffer when Singapore Airlines is thrown in the mix. Singapore Airlines recently bought a 10 per cent stake in Virgin and the expectation is that it will increasingly move its traffic to Virgin.

If seems the end game for Virgin is to turn the tables on Qantas from a situation where it had Virgin in a pincer move, to one where Virgin has Qantas in a pincer move, with Virgin hovering above Qantas, Tiger hovering above Jetstar and Skywest hovering over QantasLink with the three lowest operating cost models.

For Qantas' part, it won't give up easily. It is pinning a lot of hope on its deal with Emirates, which officially kicks off at the end of March, subject to regulatory approvals.

It is also trying to develop a strategy in Asia, with the launch of Jetstar Japan and Jetstar Hong Kong as part of a plan to beef up its footprint in an important region for Australia.

Then there is its lucrative loyalty program business, which it continues to expand, along with a dramatic program to overhaul its international business. But aviation isn't for the faint hearted.